Exploring the implications of Basel III Liquidity Standards for Africa
This blog was originally published in French on a Think-Tank website (L'Afrique des Idées).
In 2007, the world was hit by the most severe economic crisis since the Great Depression of 1929. The financial crisis exposed several weaknesses in the global economy, and particularly in the liquidity management of banks . In order to strengthen and ensure a sound financial system, the Basel Committee on Banking Supervision (BCBS) established two new liquidity standards, the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) in 2010, under the Basel III agreements. These ratios have gradually come into effect since 2015. The NSFR will come into effect in 2018 and will be followed by the Liquidity Coverage Ratio in 2019.
Unfortunately, most African countries have not yet adopted these liquidity standards—according to a 2015 FinAfrique report, the West Africa Economic and Monetary Union (WAEMU) and members of the Central African Economic and Monetary Community (CEMAC) are still migrating to Basel II, while Nigeria is already in compliance with Basel II standards. Despite the slow progress, these countries nevertheless aspire to applying Basel III within their domestic financial markets. What might be the impact of these liquidity standards on African economies, and on their respective financial sectors?
The Liquidity Coverage Ratio (LCR) The LCR is a stress test which aims to anticipate and avoid market-wide shocks. Banks which adhere to the liquidity coverage ratio are guaranteed to have the necessary assets to ride out any short-term liquidity disruptions. To calculate the ratio, the stock of high-quality liquid assets is divided by the net outflows over the next 30 calendar days. Highly liquid assets correspond to level 1 (cash, reserves at the central bank level, etc.) and level 2 assets (covered bonds rated AA- or higher and assets with 20% risk weighting).
The Net Stable Funding Ratio (NSFR) By adhering to the Net Stable Funding Ratio, banks become more resilient and are better-prepared for liquidity risks over the long-term. It is calculated by dividing the amount of available stable funding by the amount of stable funding required. It can then be defined as the proportion of long-term assets  financed by long-term or stable financing . The stable funding available relates to the share of capital and liabilities maturing in excess of one year. The required stable financing corresponds to the various assets held by the bank concerned, including its off-balance sheet exposure . As a result, using the NSFR, regulators can encourage banks to maintain a stable financing profile in relation to the composition of their assets and off-balance sheet activities. By applying the NSFR, banks will use stable sources of financing in order to reduce the likelihood of disruption to the bank's regular sources of liquidity, which is expected to reduce the probability of bankruptcy.It also aims to reduce the excessive use of short-term wholesale financing . Banks can indeed be encouraged to expand their balance sheets very quickly. For this, they can rely on cheap short-term wholesale financing. And yet, a rapid increase in the size of the balance sheet may weaken their ability to respond to liquidity shocks.
The limits of Basel III liquidity regulation Although the new regulations of the Basel III framework seem to eliminate much of the bank liquidity risk and represent a significant advance in the management of liquidity risk, their application can generate new problems. The LCR prioritizes low-risk assets such as government bonds. In order to meet this regulatory requirement, banks may prefer to lend to governments, and they therefore have less incentive to lend to investors. This will reduce private investment. This decline in private investment may lead to a slowdown in economic activity if it is not offset by increased public investment, such as through bank loans. Moreover, we have all witnessed the 2011 sovereign debt crisis in the euro area—this crisis has shown that the risk of default by a state may exist, and therefore government bonds may indeed be risky and illiquid.
The Net Stable Funding Ratio (NSFR) is also flawed. The main limitation of this ratio is that it goes against one of the main intrinsic functions of banks: Maturity transformation. Banks transform short-term funds, such as savings deposits, into long-term loans, such as mortgages. Thus, with a view to reducing the maturity mismatch—all while requiring banks to finance a large portion of long-term assets with stable funds—the long-term structural liquidity ratio could push banks to offer less credit and non-optimal resource allocation. On the one hand, an inefficient allocation of resources will negatively impact the performance of banks and, on the other hand, the narrowing of credit activity would lead to a slowdown in economic activity.
Basel III liquidity risk regulation: danger or solution for Africa? Banks are also known to be the lungs of economies. They fund savings mainly through their loans, which they give to economic agents. They ration loans and fix the remuneration of these loans (debit interest rate) according to the risk profile of potential borrowers. The payment of the loans constitutes the risk premium taken by the bank. Thus, the higher the risk, the higher the interest rate will be. Banks also provide credit according to the economic environment. They will be more incentivized to produce loans at relatively low rates when they have confidence in the economic environment.
Generally in Africa, banks can often incur risks when faced with potential borrowers because of their opacity. This opacity is supported by the non-negligible weight of the informal sector (25% to 65% of GDP, according to the IMF). The lack of information on loan applicants is an essential element that reduces the lending activity of banks and especially that requires high interest rates. In addition, there are no important structures that can increase the incentive for banks to lend. In developed countries, for example, there are structures that support the unemployed (such as employment in France). These structures guarantee an income stream for workers in the event of job loss, thus reducing the risk of default when these workers wish to have a loan. The absence of such structures in most of Africa, does not facilitate the establishment of credits from banks.
While this problem could be alleviated with the introduction of insurance, the insurance premium would make the total cost of loans larger. In addition, for most loans granted, the bank requires life insurance that will guarantee repayment of the loan in the event of the death of the borrower. In Africa, life expectancy is on average 60 years, whereas in France, it is 82 years, according to the French public information radio France Info. In a 2016 WHO press release, twenty-two countries in sub-Saharan Africa have a life expectancy of less than 60 years. We end up with much higher insurance premiums in Africa, which means that the loan costs are significant enough to support the potential borrower. The importance of these costs obviously has a negative impact on loan demand. The bank rate is also quite low in Africa. It is 10% in sub-Saharan Africa, it is between 7.4 and 8% in the WAEMU zone, and it is close to 40% in Morocco, against 99% in France, according to the Africa24 news channel.
As a result, banks collect fewer deposits because of hoarding of households. And yet to make the loans, the bank uses essentially its deposits. Thus, the low collection of deposits discourages the setting up of loans and encourages more rationing credits. Finally, the risk of political instability in some countries does not also favor the establishment of loans because it deteriorates the confidence of bankers.
Because of these aspects, African banks limit their lending activities and demand high interest rates.
As mentioned above, the new Basel III liquidity requirements may encourage banks to lend less. Thus their application in Africa, a continent already suffering from lack of funding, could be harmful for the performance of African banks and especially for African economies. It would be interesting to think of a regulation according to the level of development of the countries.
Sources and footnotes
Basel Committee on Banking Supervision, 2010, Basel III: International framework for liquidity risk measurement, standards and monitoring.
Idrissa Coulibaly, 2015, L’impact des réglementations internationales BÂLE I, II & III sur le système bancaire africain (The Impact of Basel I, II & III international standards on the African banking System), FinAfrique
 The term liquidity has a large scope. Three basic definitions are possible: (i) the liquidity of a financial security defined as the ease of selling it without losing value; (ii) the liquidity of the market defined as the possibility of trading on this market a large quantity of securities without influencing their prices; (iii) the liquidity of financing for a firm that can be defined as the ability to honor its obligations at time over a given period.
 These are assets that can not be liquid or used for at least one year.
 The sources of long-term financing are resources spread over more than one year (capital, long-term debts, etc.).
 The off-balance sheet activities of a bank are all activities that are not recorded in its balance sheet. These include credit commitments for example.
 In addition to the traditional source of financing used by banks (deposits), they also use wholesale financing. This source of financing mainly corresponds to US banks, federal funds, foreign deposits and brokered deposits. These types of financing are most often short-term. As a result, a bank that is highly dependent on these types of financing can easily face a liquidity problem if it is perceived as risky or poorly capitalized.
About the Author
Alassane Diabaté is a PhD candidate in Banking Economics at the University of Limoges (France) and conducts his research in the Laboratory of Economic Analysis and Prospects (LAPE). His key interests are about the banking system (regulation, capital structures, risks and banking strategies). Alassane also teaches at the same university in macroeconomics, monetary macroeconomics and microeconomics.